The Retirement Saver’s Conundrum: Roth 401(k) or Traditional 401(k)?
Socking away as much money as possible for retirement is, by no means, a “hidden secret” nor complex, nuanced retirement strategy. With or without formal advice from a wealth planner, most people intuitively know saving money is the foundational “blocking and tackling” building block required for a stable retirement. But after the table-stakes of retirement planning is established, complexity and analysis come into play, most notably the amount to save when factoring in lifestyle needs, retirement timeframe, education planning, taxes, and estate planning goals. This is where experienced and well-informed advice can add value and peace of mind.
But recently, with the increasing availability of Roth 401(k) options in many employer plans, the decision on tax deferred vs. after tax contributions has added another layer of complexity to the retirement savings calculus. In short, investors and savers are now faced with the question of if they should elect a Roth option and how much of their hard-earned retirement savings dollars should be put into a traditional tax deferred savings plan (i.e. tax deferred 401(k), 403(b), etc.) versus a Roth (after-tax) plan?
Much like our friends in the legal, medical, and tax advice-giving business, we too must default to the stock answer frustrating the inquirer: “It depends.”
The Tax Rate Tradeoff Decision
To analyze this issue, we must first establish the basic issue at hand. In many defined contribution employer retirement plans, (i.e. 401(k)) employers may offer employees the choice to contribute all or some mixture of their contributions to a Roth or Traditional version of the plan. The primary difference between the two plan options is: traditional plan contributions are pre-tax, effectively lowering an employee’s taxable income and lowering annual federal (and other) tax liabilities. Put another way, a $1,000 contribution with a 30% personal tax rate subjects $700 taxes instead of the full $1,000. The tradeoff for this attractive tax break is, of course, when these retirement dollars are disbursed out (either pre-RMD age or at the required beginning age of 73), tax is owed on the amount of the withdrawal. In addition, heirs to these funds will owe tax on withdrawals and for non-spouse heirs, the disbursement schedule is accelerated. A Roth plan works the opposite way. Employees do NOT enjoy lower tax liability with contributions but, in exchange, withdrawals from these accounts are not taxed and importantly, heirs to these funds also avoid tax liability. To use our previous example, the full $1,000 contribution is still counted as fully taxable income.
Making the Educated Guess
Making this decision would be pretty straightforward if we knew future market growth rates, future tax rates, and the exact day a person will die. Obviously, those are unknowable with certainty. But we can make some educated guesses and increase our odds of making the right call by knowing personal circumstances.
The simple way to consider this decision is to first determine the current federal, state, and local tax rate. If the taxpayer is in higher brackets (30% or more all-in), it can make sense to take the deferral now (by contributing to the traditional tax deferred plan) with the educated guess that, in retirement, the retiree will be in a lower tax bracket. This allows the taxpayer to benefit from the relatively high rate for the tax deduction while working, with the expectation of a lower tax rate in retirement. One downside to this strategy is, under the SECURE ACT, non-spouse heirs to tax deferred accounts must empty these accounts within 10 years, and distributions to the heirs are included as ordinary and taxable income in what could be their peak earning years.
Conversely, taxpayers in lower tax brackets may decide to forgo the tax deferral and contribute to the Roth plan knowing that, in retirement, future withdrawals will be tax free and heirs will enjoy tax-free distributions as well.
Of course, tax brackets move throughout decades of a career so “set it and forget it” is not wise. Savers need to adapt to changing tax laws, income tax brackets, growth rates, and health expectations. In addition, the pre-existing mix of pre-tax vs. After tax retirement savings also plays a factor in where to direct future contributions. So, clearly, this isn’t a simple decision.
The Best of Both Worlds
In working with a broad array of clients, we’ve found a sweet spot or ideal set of circumstances that help maximize tax efficiency with a multi-decade approach requiring diligence and sticking to the plan. This is the heart of customized wealth management: tailoring a plan specific to the family and not relying on “rules of thumb” or general advice.
People or couples that are high earners and good savers, with a realistic chance of retiring “early” (usually before 65), can really leverage the tax code to work in their favor with a tax strategy that goes well beyond a one-year calculation. In these situations, we find people in high tax brackets can benefit from choosing the tax deferral at their current high rates, which can save 30% or more in taxes with each contribution. But what about the high tax rates on these dollars upon withdrawal?
That’s where we execute strategic Roth conversions in the first years of retirement before claiming Social Security and before RMDs kick in (currently age 73). For someone retiring at age 60 with substantial savings in tax deferred accounts, executing a well-defined Roth conversion strategy for those 10+ years of “low income” can save on taxes in working years while paying lower tax rates that we can control with the proper calculation of annual Roth conversions at an attractive rate. So instead of paying little to no taxes in the first year of retirement (due to minimal taxable income) and “wasting” the low brackets, well-constructed Roth conversion amounts can voluntarily pay tax in say the low-teens rates instead of paying much higher rates when the full brunt of RMDs (combined with Social Security) come due when clients are in their 70’s. (Please note: we must also be mindful of other distinct tax brackets including capital gains rates and IRMAA (Medicare) surcharges when adding income). This savings can be in addition to a taxpayer previously benefiting from the high tax savings while working! This is effectively using the Golden Window of Tax Planning as described and depicted in the article from November 2021.
Additionally, heirs will be thrilled to inherit a more attractive mix of tax-free assets that won’t incur higher taxable income on required distributions when they could be in higher tax brackets.
Bottom Line
In reality, there is no “perfect” strategy because so many variables shift over the decades. Tax rates, tax brackets, living expenses, market growth rates, and life expectancy all impact the degree a family can benefit from this strategy. But having a multi-decade plan and a tactical yearly execution can, if executed correctly, save retirees on what is their largest cash outflow over retirement years: taxes.
Disclaimer: Information contained herein is current as of 6/30/2024. It is subject to legislative changes and not intended to be legal or tax advice. Please consult your qualified tax advisor regarding your specific circumstances. The material is provided for informational purposes only on an “as is” basis. It’s completeness and accuracy are not guaranteed.